The Price Earnings Ratio Method is one of the most basic and widely used methods for valuing companies. In this approach, the price of a company’s share listed on an exchange is divided by its reported Earnings Per Share (“EPS”). The Price to Earnings Ratio thus derived is compared with the industry PE Ratio to determine if there is potential upside or if the share is overvalued, undervalued or fairly valued.

Price Earnings Ratio Method

Simply put, P/E (Price Earnings) Ratio indicates how much the market is willing to pay today, to get each rupee of the future earnings of the company.

The other day, I was looking at the PE multiple of Tata Motors on a finance portal, I was surprised as the P/E they reported was 140.28 x!

Really?

Calculation methodology
Many finance portals report PE multiples on standalone basis, even for companies where a majority earnings are derived from subsidiaries. This will obviously present an incorrect picture.

Companies can choose to report either “Standalone” or “Consolidated” results. Standalone financial numbers indicate the financial performance of a company as a single entity. Consolidated results take into account the performance of subsidiaries and the share of minorities and associate companies.

How much could this affect the valuation of a company?
Let’s take the case of Tata Motors:
Tata Motors on a standalone basis will look a very different entity. However when you consolidate and factor in the performance of Jaguar Land Rover, the results will dramatically vary.

For the First Quarter (Q1) of FY 2014
Tata Motors Net Profit/ (Loss) (Standalone): Rs. 703.26 Cr.
Tata Motors Net Profit/ (Loss) (Consolidated): Rs. 1,726.07 Cr.

The consolidated results are 145.44 % higher. On a standalone basis, Tata Motors Limited is trading at a P/E Multiple of 140.28 x, making it an expensive stock (i.e. overvalued). However, on consolidated basis, it trades at a P/E Multiple of 11.60 x (this takes into account the Jaguar Land Rover earnings), making it cheap (i.e. undervalued). (*Market Price as on October 7, 2013)

Remember, it is extremely important to consider the consolidated earnings when calculating the PE ratio. There are many examples of companies where the parent company is in fact making losses yet on a consolidated basis the entity is profitable and vice versa. Tata Motors is a leading example of how a turnaround in subsidiaries can augment the overall performance. The turnaround of Jaguar Land Rover (JLR), over the past couple of quarters, has led to the subsidiaries contributing nearly 80% of the quarterly profit of Tata Motors.

Similarly, it would be unreasonable to do an analysis of Tata Steel, while ignoring Corus. On a standalone basis, Tata Steel Limited is trading at a P/E Multiple of 5.95 x. However, on consolidated basis, it trades at a P/E Multiple of (4.34 x) (taking into account the Corus earnings).

Thus, before evaluating the investment potential of a company, you must pay close attention to the revenue stream. For companies operating with one or more subsidiaries and/or associates only consolidated financial statements will present a complete picture of the financial position and as such, it will be wrong to calculate the P/E ratio using only the standalone results.

Then why do many portals report P/E on standalone basis?
In their quarterly reporting, some companies choose to report consolidated financials while others report only the standalone numbers (i.e. the companies can choose their quarterly reporting format and must mandatorily file their consolidated financials only on an annual basis). There are many companies like Tata Motors, State Bank of India, Tata Power etc which report quarterly consolidated results while others like ONGC, Hindalco, and Maruti Suzuki etc choose not to reveal consolidated results until the end of the financial year. Further, there are companies which operate with no subsidiaries like Hero MotoCorp Limited, Ashok Leyland, Colgate-Palmolive (India) Limited etc, so their earnings will naturally be on standalone basis.

So much for consistency!

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